Battle for the Bulge

Normand Gendron | May 1, 2008

Pension surplus: whose money is it anyway?

The pension plan surplus ownership debate began with the Dominion Stores case in 1986—a debate that is alive and continues stronger than ever today. With a lack of clarity around surplus issues in pension legislation, over the years, the courts have applied classic trust principles in their decisions on pension plan surplus issues. The result has been that employers haven’t been able to access surplus freely.

Plan sponsors are pointing to the asymmetry in the treatment of surplus and deficits as a barrier to keeping defined benefit (DB) plans alive. Here is a recap of the issues involved and recommendations on what needs to be done to help resolve these issues.

The Battleground

While the documents that created the plan and the pension fund should establish the authority for ownership of any surpluses that may occur, many originating documents drafted in the 1940s, ’50s and ’60s did not anticipate the litigious environment that has developed in Canada over the past two decades. Some documents did not initially preserve the employer’s right to surplus ownership. Others contained language indicating that the assets were for the exclusive benefit of the plan members, which has been equally problematic for plan sponsors.

When it comes to pension costs, plan sponsors want the greatest possible predictability and the flexibility to manage those costs. Members, on the other hand, want benefits security. Greater security can be achieved through higher contributions — in other words, funding with a margin. The problem is that court decisions regarding the use and ownership of surplus have made plan sponsors wary about funding more than the minimum, which has the effect of increasing the volatility of pension costs and reducing benefits security.

Opposing Sides

So, who should own surplus, and how should it be used? Here are the main arguments for both sides.

Plan sponsor’s argument – We support the risk of funding shortfalls through deficiency amortization payments. We should therefore benefit from any surplus (the positive side of that risk).

Let’s examine each argument more closely. With respect to the plan sponsor’s risk/reward argument, it is important to recognize that members also bear some of the risk of underfunding. If the employer goes broke and the plan is underfunded, plan members could end up losing part of their pensions. In addition, the plan sponsor can adjust other parts of the members’ compensation when the pension burden is too high. During the life of the plan, there will be periods of higher funding costs and others when contribution holidays can be taken, reducing the funding costs in those years. Therefore, the sponsor is on the hook in bad times, but can recoup losses during good times. The plan sponsor is responsible for funding deficits and certainly bears some of that risk, but let’s not lose sight of the fact that there are ways to pass on that risk to the plan members through downsizing and compensation adjustments.

Looking at the plan member’s side, the deferred compensation concept does not apply well in a DB environment, since it is difficult to assign a deferred component value to an individual’s overall compensation. In a DB plan, younger members subsidize older members, and members who terminate early subsidize members who stay until retirement. Furthermore, it has not been demonstrated that there is a direct impact on cash compensation when sponsors are faced with special payments that reach 10% to 15% of payroll. We have not seen salaries drop by 10% or 15%, which would have been the direct consequence of applying the deferred compensation concept. Pushed to the limit, only defined contribution plans provide deferred compensation because the employer’s contribution is earmarked in the name of the employee. Whether that identifiable amount stacks up against a DB promise is a whole different issue.

A Balanced View

Ultimately, the solution to the surplus issue lies somewhere in between these two opposing and apparently irreconcilable views. Here are some of the key changes needed to move forward with pension plan surplus issues in Canada.

1) The government should introduce legislation to ensure that pension plans are interpreted under contract law as opposed to trust law. Under contract law, a general power of amendment would allow an employer to amend the plan in respect of surplus ownership. Since surplus ownership would not be governed by classic trust law principles, surplus ownership would not be established at the time that the trust was originally established.

2) Pension plan regulation should be clear on surplus ownership and how it will be determined. Some new potential provisions include the following:

Allowing the use of a side fund for deficiency contributions. Money in the side fund could be used for contribution holidays if it is no longer needed to cover liabilities.

Establishing a “banker’s rule” arrangement whereby a sponsor could recuperate deficiency payments made to the fund when the fund returns to a surplus position (with or without a safety margin being required).

In the absence of clear rules, providing for an arbitration mechanism that would allow each party to present its arguments.

3) A safety margin should be held in the fund before any contribution holidays are taken or benefit improvements adopted. This would benefit both sponsors and members, as the plan could sustain greater fluctuations in asset values without incurring deficiency payments while the members would benefit from greater benefit security.

4) The maximum surplus allowed by the Canada Revenue Agency should be increased to allow for the buildup of greater margins.

British Columbia, Alberta, Ontario and Nova Scotia have all indicated that a review of the pension standards in their respective provinces will be conducted in 2008. As part of these reviews, provincial regulators will have to deal with the regulatory framework for pension surplus. In a best-case scenario, they will recognize the need for better risk/reward symmetry and will be brave enough to make the necessary changes to improve the DB pension system.

The employer withdrew $56 million from the pension fund without consulting plan members. The employer considered the surplus its own rightful property. The Supreme Court of Ontario ruled against the employer and ordered the employer to return the surplus to the pension fund. According to the court, while the most recent language in the plan documents suggested that the employer had ownership of the surplus, the original intention was to keep the surplus in the plan in order to increase members’ benefits. The decision has resulted in employers being unable to access surplus without entering into a surplussharing agreement with employees.

1994 –Schmidt v. Air Products of Canada Ltd.

Two companies merged to form Air Products Canada Ltd. Both companies sponsored defined benefit (DB ) pension plans, and both plans had surpluses. The plans were amalgamated to form two identical plans, which were terminated in 1988 with surplus remaining. The Supreme Court of Canada found that one of the plans was subject to a trust, and that the plan amendments made to distribute surplus to the employer were illegal. However, the court stated that the text did permit contribution holidays. The other plan was not subject to a trust, so contract law would determine the surplus ownership.

1995 –Chateauneuf v. TSCO of Canada Ltd.

This class action suit on behalf of employees and former employees of the Singer Company addressed the ownership of surplus and the validity of contribution holidays. The Quebec Court of Appeal confirmed that pension funds are a distinct patrimony (i.e., distinct from the employer’s assets and exclusive property for the benefit of the plan members), and surplus funds cannot be used for the employer’s own purposes.

2004 –Monsanto Canada Inc. v. Superintendent of Financial Services

Monsanto Canada Inc. had a plant closure and staff reduction program and voluntarily declared a partial windup of the plan in 1997. A $3.1 million surplus was attributed to the partial windup group. Ontario’s Superintendent of Financial Services refused to approve the windup report because it did not deal with the distribution of the surplus. Ultimately, the Supreme Court of Canada upheld the Superintendent’s position, and Monsanto was required to distribute the surplus assets as of the date of the partial windup.

The court determined that surplus assets derived from a pension plan that was subject to a trust could not be used to fund liabilities derived from another plan that was not subject to that trust. The court ruled that the assets and liabilities of the pension plans of merging companies must be kept completely separate.

2006 –Nolan v. Ontario (the “Kerry Case”)

In late 1999, Kerry added a defined contribution (DC ) component to its DB plan and took a contribution holiday from the DC contribution obligation. The issue was the use of DB surplus assets to cross-subsidize contributions to the DC component of the plan. The Ontario Divisional Court concluded that, while Kerry could take a contribution holiday in respect of DB funding obligations, it could not take a contribution holiday in respect of DC funding obligations because of restrictive historical trust wording. The Ontario Court of Appeal overturned the verdict and held in favour of Kerry. In early 2008, the Supreme Court of Canada granted leave for the case to be heard.